What I say unto you I say unto all, watch. Mark 13:37

December 05, 2010

China’s credit bubble on borrowed time as inflation bites

The Royal Bank of Scotland has advised clients to take out
protection against the risk of a sovereign default by China as one of its top
trade trades for 2011. This is a new twist.

It warns that the Communist Party will have to puncture the
credit bubble before inflation reaches levels that threaten social stability.
This in turn may open a can of worms.

“Many see China’s monetary tightening as a pre-emptive tap on
the brakes, a warning shot across the proverbial economic bows. We see it as a
potentially more malevolent reactive day of reckoning,” said Tim Ash, the bank’s
emerging markets chief.

Officially, inflation was 4.4pc in October, and may reach 5pc
in November, but it is to hard find anybody in China who believes it is that
low. Vegetables have risen 20pc in a month.

The Communist Party learned from Tiananmen in 1989 how
surging prices can seed dissent. “Inflation is a redistributive mechanism in
favour of the few that can protect living standards, against the large majority
who cannot. The political leadership cannot, will not, take risks in that
regard,” said Mr Ash.

RBS recommends credit default swaps on China’s five-year
debt. This is not a forecast that China will default. It is insurance against
the “fat tail risk” of a hard landing, with ramifications across Asia.

The Politburo said on Friday that China would move from
“relatively loose” money to a “prudent” policy next year, a recognition that
credit rationing, price controls, and other forms of Medieval restraint are not
enough. The question is whether Beijing has already left it too late.

Diana Choyleva from Lombard Street Research said the money
supply rose at a 40pc rate in 2009 and the first half of 2010 as Beijing stoked
an epic credit boom to keep uber-growth alive, but the costs of this policy now
outweigh the benefits.

The economy is entering the ugly quadrant of cycle –
stagflation – where credit-pumping leaks into speculation and price spirals,
even as growth slows. Citigroup’s Minggao Shen said it now takes a rise of ¥1.84
in the M2 money supply to generate just one yuan of GDP growth, up from ¥1.30
earlier this decade.

The froth is going into property. Experts argue heatedly over
whether or not China has managed to outdo America’s subprime bubble, or even
match the Tokyo frenzy of late 1980s. The IMF straddles the two.

It concluded in a report last week that there was no
nationwide bubble but that home prices in Shenzen, Shanghai, Beijing, and
Nanjing seem “increasingly disconnected from fundamentals.”

Prices are 22 times disposable income in Beijing, and 18
times in Shenzen, compared to eight in Tokyo. The US bubble peaked at 6.4 and
has since dropped 4.7. The price-to-rent ratio in China’s eastern cities has
risen by over 200pc since 2004.

The IMF said land sales make up 30pc of local government
revenue in Beijing. This has echoes of Ireland where “fair weather” property
taxes disguised the erosion of state finances.

Ms Choyleva said China drew a false conclusion from the
global credit crisis that their top-down economy trumps the free market, failing
to see that the events of 2008-2009 did equally great damage to them – though of
a different kind. It closed the door on mercantilist export strategies that
depend on cheap loans, a cheap currency, and the willingness of the West to
tolerate predatory trade.

China is trying to keep the game going as if nothing has
changed, but cannot do so. It dares not raise rates fast enough to let air out
of the bubble because this would expose the bad debts of the banking system. The
regime is stymied.

“The Chinese growth machine is likely to continue to function
in the minds of people long after it has no visible means of support. China’s
potential growth rate could well halve to 5pc in this decade,” she said.

As it happens, Fitch Ratings has just done a study with
Oxford Economics on what would happen if China does indeed slow to under 5pc
next year, tantamount to a recession for China. The risk is clearly there. Fitch
said private credit has grown to 148pc of GDP, compared to a median of 41pc for
emerging markets. It said the true scale of loans to local governments and state
entities has been disguised.

The result of such a hard landing would be a 20pc fall in
global commodity prices, a 100 basis point widening of spreads on emerging
market debt, a 25pc fall in Asian bourses, a fall in the growth in emerging Asia
by 2.6 percentage points, with a risk that toxic politics could make matters
much worse.

It is sobering that even a slight cooling of China’s credit
growth led to economic contraction in Malaysia and Thailand in the third
quarter, and sharp slowdowns across Asia. Japan’s economy will almost certainly
contract this quarter.

Albert Edwards from Societe General said the OECD’s leading
indicators are signalling a “downturn” for Asia’s big five (Japan, Korea, China,
India, and Indonesia). The China indicator composed by Beijing’s National Bureau
of Statistics has fallen almost as far as it did at the onset of the 2008 crash.

“I remain convinced we are witnessing a bubble of epic
proportions which will burst – catching investors as unawares as the bursting of
the Asian bubbles of the mid-1990s. Ignore these indicators at your peril,” he
said.

In a sense, inflation is a crude way of curbing China’s
export surpluses and therefore of resolving a key trade imbalance that lay
behind the global credit crisis.

If China continues to stoke inflation – and blaming the US
Federal Reserve for its own errors help – there will no longer be any need for a
yuan revaluation against the dollar, and the US Congress can shelve its
sanctions law.

On a recent visit to a chemical plant in Suzhou, I was told
by the English manager that wage bonuses for staff will average nine months pay
this year. This is what it costs to keep skilled workers. His own contract is
fixed in sterling, which has crashed against the yuan over the last two years.
“It is a sobering experience,” he said.

China may have hit the “Lewis turning point,” named after the
Nobel economist Arthur Lewis from St Lucia. It is the moment for each catch-up
economy when the supply of cheap labour from the countryside dries up, leading
to a surge in industrial wages. That reserve army of 120m Chinese migrants
everybody was so worried about four years ago has already dwindled to 25m.

China’s problem is that this is happening just as the aging
crisis starts to bite. The number of workers will decline in absolute terms
within four years. The society will then tip into precipitous demographic
decline. Unlike Japan, it will become old before it is has built a cushion of
wealth.

If there is a hard-landing in 2011, China’s reserves of $2.6
trillion – or over $3 trillion if counted fully – will not help much. Professor
Michael Pettis from Beijing University says the money cannot be used internally
in the economy.

While this fund does offer China external protection, Mr
Pettis notes wryly that the only other times in the last century when one
country accumulated reserves equal to 5pc to 6pc of global GDP was US in the
1920s, and Japan in the 1980s. We know how both episodes ended.

The sons of Mao insist that they have studied the Japanese
debacle closely and will not repeat the error. And I can sell you an ocean-front
property in Chengdu. †